Beat Billions, as our regular readers know, is dedicated to finding attractive investment opportunities in small-cap stocks. However, this does not stop us from periodically revisiting the few billion-dollar giants we love. Facebook Inc. (FB) is one of those companies, and we believe shares are still undervalued even if we incorporate conservative growth assumptions.
Facebook, as the global leader of the social media industry, is benefiting from competitive advantages that are helping the company generate sustainable earnings and revenue in the long term. Facebook, with over a billion daily active users, is a direct beneficiary of the exponential growth of digital advertising. The management of the company, led by Mark Zuckerberg, has implemented various measures to diversify the revenue sources as well, which has improved the long-term prospects of the company. The virus-induced market crash has sent the Facebook share price tumbling to the lows seen in mid-2018, which creates an anomaly between the economic reality of the company and its market value. Shares are trading below the intrinsic value, suggesting a possible undervaluation.
Facebook, Inc. operates social media platforms to enable people to connect. The main products of the company include Facebook, Instagram, and WhatsApp. In addition, the company develops Oculus, a virtual reality hardware and software solution to help people interact. The Facebook platform, not surprisingly, accounts for the bulk of company revenue.
The company earns the majority of its revenue by displaying advertisements on both Facebook and Instagram. For instance, in the fourth quarter of 2019, advertisement revenue accounted for 98% of total revenue, while sales of Oculus accounted for the remaining two percent.
The primary strategy of the company is to grow its user base and then monetize this userbase slowly.
Acquisitions have played a key role in the growth of the company as well and will likely remain one in the future.
Since its establishment in 2005, Facebook has acquired 84 companies, according to data from Crunchbase. This includes the billion-dollar acquisitions of WhatsApp and Instagram as well.
The COVID-19 pandemic has disrupted the industry outlook for many business sectors of the world, and the same is true for Facebook as well. Therefore, an analysis of Facebook’s prospects would not be complete without an evaluation of how the novel coronavirus will impact the earnings of the company, both in the short and long term.
As disclosed earlier, Facebook’s primary source of income is advertisement revenue. Historically, the global advertising industry has contracted during times of economic downturns. This is natural as a decline in business activities prompt businesses to cut down on their marketing budgets. Global economic growth and the growth of the advertising industry are positively correlated.
During the global financial crisis of 2008, advertising revenue declined drastically.
A similar decline can be expected this time around as well. According to the Bloomberg recession prediction model, there’s a 100% chance of a recession within the next 12 months in the United States. In other words, America is already in a recession for the first time since the fallout of the financial crisis.
What is noteworthy, however, is that advertising revenue has quickly gained traction as soon as economic growth returned in 2010. This is good news for Facebook investors as the International Monetary Fund predicts the economy to recover in 2021. In fact, according to the latest data published by IMF, the global economy will grow by 5.8% in the next year, which would be the highest annual percentage growth recorded in the last three decades.
In the short-term, many companies that depend on advertising revenue, including Facebook, will fail to grow their earnings. This could continue through the end of this year. However, in 2021, tables will turn, and the industry will once again be on the right track. Therefore, an unwavering focus on the long term is required from investors.
Facebook will benefit from another important macroeconomic development as well. Digital ad spending accounted for approximately 50% of the total advertising industry revenue in 2019. According to eMarketer, the market share of digital ad spending is expected to grow to 60.5% by 2023.
Facebook will be a direct beneficiary of this shift as one of the go-to digital advertisement space providers in the world.
The competitive landscape is supportive of Facebook’s growth as well. The company, by far, is the largest social media platform in the world and is benefiting from a network effect – the value of the platform increases with every addition of a new user. For a newcomer to the social media space, there is no other viable alternative, making Facebook the go-to option.
Based on the information revealed in this segment of the analysis, it would be reasonable to conclude that Facebook, as the market leader in the industry it operates, is benefiting from significant competitive advantages. This, in return, will lead to attractive earnings in the future. The long-term outlook for the industry is positive as well.
Financial analysis and valuation
Facebook, in every sense of the word, has been a blockbuster growth story in the last decade. Macroeconomic tailwinds and the visionary management of the company has been behind the unfathomable success of the company. Revenue of the company has grown by double-digits each year since 2010, which is an indication of the company’s positive momentum.
The net income of the company, on the other hand, has grown from $606 million in 2010 to $18.45 billion in 2019.
High debt-to-equity ratios are common among growth companies. However, Facebook has achieved this unprecedented growth while not assuming any debt, which is testimony to how the management attempts to keep the company in strong financial health. The zero-debt balance sheet of the company is a unique strength that enables Facebook to remain solvent even if the going gets tough.
Facebook has consistently generated an above-average return on equity (ROE) and return on invested capital (ROIC) than its peers, which is a sign that the company is outpacing its peers from a financial performance perspective. Warren Buffett, arguably the most successful investor the world has ever seen, is a huge fan of companies that generate consistently high ROE. In fact, he believes it’s a reliable measure of a company’s ability to generate sustainable earnings for a prolonged period. In Berkshire’s annual letter to shareholders in 1977, Buffett wrote:
“Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”
Twitter and Snapchat are two of the closest rivals of Facebook. Snapchat has not been able to generate a positive return on equity since its Initial Public Offering in 2017. Twitter, on the other hand, has improved its profitability in the last couple of years and its ROE is now comparable to that of Facebook. However, Twitter is still a much smaller company in comparison that brought in $3.5 billion in revenue in 2019, in comparison to Facebook’s $70 billion.
The operating margin of the company, however, has deteriorated in the last couple of years.
The primary reason behind this decline is the increase in operating costs related to cybersecurity. The billion-dollar fines imposed on Facebook as a result of security breaches has prompted the management to take measures to prevent such instances from happening again. An analysis of the components of operating costs reveals this.
|Year||Selling, general, and admin expenses as a percentage of revenue|
In the third-quarter earnings conference call in 2018, Facebook CEO Mark Zuckerberg confirmed that the company would be doubling its cybersecurity headcount by 2020, a promise that the company has kept.
In the short-term, this decline in margins will not be embraced by investors. However, the expenditure on improving the security measures will prove to be a blessing for the company in the future as this would, undoubtedly, improve the brand image of the company. User trust is paramount to the success of a social media platform, and the absence of privacy breaches will restore some lost trust on Facebook.
The free cash flow of the company has grown to multi-billion dollars as well, which is another indication of Facebook’s financial strength. In 2019, the company had free cash flows of $21.2 billion in comparison to $405 million in 2010.
Based on a discounted free cash flow model, the intrinsic value of Facebook shares was calculated as $227.75. The major assumptions used in the model are listed below.
- Net income growth of 25% in the next 5 years, which is expected to slow down to a terminal growth rate of 2% in the 10th year.
- Cost of equity of 7.39%
- Earnings retention ratio of 75%
Even from an earnings multiples perspective, shares can be deemed as undervalued. According to data from Morningstar Research, Facebook shares have traded at a 5-year average price-to-earnings ratio of 47.85. However, shares are currently trading at a P/E of 30.2, which is an indication that shares are undervalued. There’s reason to believe that shares will converge with its historical earnings multiples in the coming years as the company is aggressively pursuing growth opportunities. For instance, Facebook invested in Jio, the largest telecommunication company in India, recently. This will enable the company to accelerate its process of monetizing WhatsApp, which has over a billion daily active users. Second, the company has unveiled a Zoom-like video conferencing application, Messenger Rooms. Both these initiatives will help Facebook secure robust growth in the coming years, which would be reflected in the market value of the company through a convergence with the historical price-to-earnings ratio.
Even from a comparable valuation perspective, Facebook seems undervalued. The publicly listed peers of Facebook include Snapchat, Twitter, and Pinterest. Out of this group, only Twitter is bringing in net profits. All the other peers of Facebook are loss-making. Twitter is currently trading at a P/E of 67, whereas Facebook, which is much more profitable, is trading at a P/E of 30. A comparison of enterprise value-to-sales can be used as a valuation measure as well, because many of Facebook’s peers do not bring in positive earnings. Even from this perspective, Facebook shares seem very attractively priced.
Twitter has a lower ratio but is less profitable than Facebook and has a debt pile, whereas Facebook is free of debt. All the valuation techniques used in this analysis point to the same conclusion; Facebook is undervalued.
Facebook’s growth story is far from over. The company looks prime to achieve growth from many fronts. First, the company is not yet done with monetizing its massive userbase. In the fourth quarter of 2019, Facebook had 2.498 billion monthly active users. Below is a breakdown of these active users by region.
|Region||Monthly active users|
|The United States and Canada||248 million|
|Rest of the world||817 million|
Even though the Asia-Pacific region accounts for the bulk of monthly active users, the average revenue per user in this region is considerably lower than the North America region. This is a confirmation that there’s massive leeway for growth for the company outside the Americas.
|Region||The average revenue per user|
|The United States and Canada||$41.41|
|Rest of the world||$2.48|
Evidently, the company is generating the bulk of revenue from the region with the lowest number of active users. Not to forget, Facebook was started with a focus on the United States and was later expanded into other regions. Therefore, it’s reasonable to believe that the company would be focusing on monetizing the user base in Asia-Pacific better as time passes by. The strategy of the company, as confirmed by the management on many occasions, is to build a loyal user base and then monetize them. Going by this strategy, it’s apparent that Facebook will eventually earn the bulk of its revenue from regions outside North America, which should lead to both topline and bottom-line growth in the coming years.
It’s well-known among the investing community that both WhatsApp and Instagram remain significantly under-monetized. The company has big plans for both these platforms. For instance, WhatsApp is targeting small business owners with its novel WhatsApp Business feature. In the coming years, the company might unveil advertising on the platform to help these small business owners market their products and services directly to consumers. WhatsApp might even enable payments on the platform, the same way WeChat does in China. Rolling out these features will make WhatsApp, with over a billion active users, a cash-cow for the company. The same is true for Instagram as well. The company launched Instagram Shopping in a bid to enable shopping on its same platform rather than directing merchants and shoppers to a third-party website to complete a transaction. In the next couple of years, the contribution from Instagram to company revenue and earnings will grow, which is another way how Facebook would be able to grow in the future.
Facebook has rolled out a plan to capture market share of the growing online dating industry as well. According to data from Visual Capitalist, online dating is now the most common way how couples meet. Match Group is the global leader of this industry and owns leading dating apps including Tinder and Plenty of Fish. However, with over two billion active users, Facebook is in a strong position to be a contender to Match Group. In September 2019, the company rolled out a dating platform in the United States and few other international markets, including Canada, Singapore, Brazil, and Argentina. The company will most likely introduce this feature to many other countries depending on the initial success.
The total revenue of the global dating industry has grown in each of the last three years, and Statista projects continued growth through 2024.
Facebook’s entry into this industry is a strategic move to grow earnings in the long run, and the extensive experience the company possesses in keeping users engaged with its products will come in handy to gain traction from this segment.
The outlook for Facebook, as evident from this analysis, is very positive. Investors should not base their investment decisions on short-term headwinds, which could lead to undesired outcomes in the future.
Risks & governance
Over the last couple of years, there has been an increase in the number of security breaches, leading to several investigations by regulatory bodies across the world. Some of these probes led Facebook to pay millions of dollars in fines as compensation to the damages. For instance, the Federal Trade Commission imposed a $5 billion fine on Facebook in July 2019 for misusing confidential data of users. These revelations resulted in temporary drops in the share price as well. The primary risk of investing in Facebook is a continuation of these privacy breaches, which results in creating a dent in consumer sentiment toward using this social media platform to stay connected with their loved ones. If security concerns persist for a prolonged time, users might look for alternative solutions, leading to a decline in the monthly and daily active users. This, collectively, will result in a drop in advertising revenue as marketers will shift along with consumers to new platforms.
A second risk of investing in Facebook is the lower internet penetration rates in emerging countries. The company, so far, has seen massive success in developed regions of the world. However, the access to the internet is still limited in some of the densely populated emerging countries, which might limit the ability of the company to achieve growth now that growth is at a point of saturation in North America and Europe.
The company, however, is proactively working on mitigating the risks from both these fronts. First, billions of dollars are invested to improve the security features of the company. Second, the company is looking at monetizing WhatsApp and Instagram in developing regions of the world until the internet penetration rate improves. Going by the billion-dollar infrastructure development projects carried out by governments outside North America and the growing middle-income society, it wouldn’t be long until the Asia-Pacific region sees a considerable improvement in the number of people with access to the internet.
Facebook shares have declined by 17% in 2020, primarily as a result of the virus-induced market crash. Global advertising revenue, on the other hand, is expected to decline as many businesses have cut their marketing budget. Both these developments are negative for Facebook. However, the company has a debt-free balance sheet, and the stay-at-home policies enacted by many governments of the world will increase social media usage. Even though Facebook will be hurt in the short term, the long-term outlook for the company remains positive as the company is in a strong position to convert this increased usage of their platforms to long-term earnings. The historical performance of Facebook is testimony to this ability.
Shares are trading at a discount to the intrinsic value of the company, and long-term oriented investors can bank on this opportunity to invest in an industry-leader at a discounted price.
Investors should note that we have not factored in Facebook’s Jio investment as we wanted to calculate an intrinsic value estimate that acts as a worst-case scenario. Beat Billions believe that Jio will accelerate the monetization process for Facebook., helping the company generate billions of dollars more in the future.
The author of this article is long FB.
**If you enjoyed this article, please consider signing-up for Beat Billions by providing your e-mail address in the box above. You will then receive a SINGLE daily e-mail with all the articles published on Beat Billions.
**We write multiple times a week so come back again to see our latest research.